Beating the Market [Archive.org URL]

You’ve heard it a million times: Nobody can beat the stock market, so just stash your investment dollars in index mutual funds and settle for “the average return.” Behind that nostrum is the so-called efficient market theory, which holds that stock prices already reflect all the available information about a company, making it impossible for anybody to get a leg up.

Efficient market theory no longer dominates the academic discipline of finance, says Robert A. Jaeger, senior market strategist at BNY Mellon Asset Management, but it has left a legacy: the notion that there is no such thing as a skilled investor, and no way to distinguish skill from luck. Not true, Jaeger argues.

Two strands of the theory challenge the notion of skill. One is the idea that “there are no free lunches”: No market inefficiencies exist that might enable investors to make money without taking risk. Risk, the argument goes, will always catch up with successful investors, reducing their returns to the norm. The second idea is that “nobody knows anything”: Investors can’t predict the future. But, Jaeger says, those who have skill as investors don’t exploit market inefficiencies or use vatic powers to see tomorrow’s stock market. They make “intelligent judgments about risk and reward.”

Efficient market theorists believe that investors are totally rational. In fact, Jaeger says, they are driven by fear, greed, and a host of behavioral “biases.” But irrationality still doesn’t create free lunches or predictable prices. Even during bubbles and panics, which are prime moneymaking opportunities for savvy investors, there are no riskless profits and no way to forecast market turning points.

Although the stock market is unpredictable, efficient market theorists are wrong to claim that it is a “random walk,” Jaeger adds. Random events can’t be explained even after the fact, but market events can.

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